This is a very interesting article from both the auditing
perspective and the investing perspective. The authors begin with a short discussion of the
Sarbanes-Oxley Act of 2002 that addresses corporate accountability. The
provisions of the act include new legal constraints on executives and expands
the protection for whistle-blowers. It creates a regulatory board to monitor
accounting firms and establishes penalties for accounting fraud. George W. Bush even
proclaimed that "The era of low standards and false profits is over." But
the authors say its not that easy. A more
destructive problem with corporate auditing is unconscious self-serving bias
that can cause even honest
meticulous auditors to unintentionally distort audits. As a result, the provisions of the Sarbanes-Oxley Act will not solve the
problem, and might even make the problem worse. The purpose of this paper is to discuss the various causes of
unconscious self-serving bias, to provide some supporting evidence from various experiments, and
to provide some recommendations related to systemic changes needed to help reduce
the problem.

The Roots of Bias

In this section the authors explain that psychologically
people interpret information in ways that benefit their self interest even when they are trying
to be objective and impartial. People tend to discount the facts that contradict
the conclusions they want and embrace the facts that support their own
viewpoints. The authors discuss some of their experiments to support the idea of
self-serving human behavior.

Accounting for Bad Accounting

This section includes a discussion of three structural aspects
of accounting that create substantial opportunities for bias to affect judgment
and three behavioral aspects that amplify the unconscious bias.

The structural aspects of accounting include:

Ambiguity - When the possibility to
interpret information in different ways exist, people tend to reach self-serving
conclusions. Accounting is full of ambiguity. In a side bar they mention Money
Magazine's annual survey of 30-50 tax professionals who always provide a wide
range of opinions related to a hypothetical tax return. They also
mention that corporate accounting is full of ambiguous questions related to
revenue and expense recognition. In one survey 67% of audit partners reported
that they negotiated with 50% or more of their clients on how to account for
various items.

Attachment - Two main points. Companies
fire accounting firms that deliver unfavorable audits. Audits are frequently
used to build relationships that lead to consulting services. Attachment breeds
bias.

Approval - The bias to approve of a
clients accounting methods. Self-serving biases increase when people are
endorsing other biased judgments that equate with their own biases.

The behavioral aspects that amplify unconscious bias include:

Familiarity - People are much less
willing to harm individuals that they know, particularly paying clients.

Discounting - Immediate consequences tend
to receive more emphasis than delayed outcomes, particularly when the delayed
outcomes are uncertain. Critical audit reports produce immediate adverse
consequences, but the cost of an unjustified positive report is distant and
uncertain.

Escalation - Minor indiscretions and
errors created by unconscious bias may evolve into conscious corruption.

The authors also discuss evidence showing that people cannot
control their biases even when they try to eliminate the effects of bias.

Problems with Proposed Reforms

The authors argue that the Sarbanes-Oxley Act does not address
the problem of bias and will not solve the accounting crisis. Although the new
rules require auditors to disclose conflicts of interest to investors, people
cannot accurately factor this information into their investment decisions and
disclosure could actually increase bias on the part of the auditors who make the
disclosures. Stricter accounting standards are also unlikely to improve the
situation since research shows that it takes very little ambiguity to generate
biased judgments.

Radical Remedies

In this last section Bazerman, Loewenstein and Moore make a number of
recommendations related to systemic changes needed to solve the auditing crisis.
Penalties are not the solution. What is needed is a new set of policies that
eliminate the incentives that create the self-serving biases - the impossible
conflicts of interest. The fundamental structure of the auditing system ensures
biased auditing and must be changed.

Their recommendations include:

1. Full divestiture of consulting and tax services.

2. Fixed, limited audit contract periods
during which they cannot be terminated, with fees set at the beginning of the contract
period.

3. Prohibit clients from rehiring the
auditing firm at the end of the contract period.